China Mutual Fund: Profit From China’s Economic Slowdown

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Over the past decade, China has become a bellwether for global economic growth; when China’s economy slows, investors assume that’s a dismal portent for the rest of the world. So it’s little surprise that the recent decline in China’s economic growth has inspired dour headlines in the financial media. But Edmund Harriss, portfolio manager of Guinness Atkinson China & Hong Kong(ICHKX), believes that investors can still find opportunities in the Middle Kingdom in the midst of a slowdown. He says the Chinese government has clearly signaled its intention to reorder its domestic economy and that international investors who focus on the right sectors can still reap profits from the country.

Ben Shepherd: Please describe your investment process.

Edmund Harriss: We primarily use a bottom-up investment discipline. However, we also employ a top-down analysis because China’s economy is so heavily policy driven that it’s important to understand how policies originate and how they’ll impact the operating environment. China’s domestic economy is actually a hybrid of state-controlled elements and free market elements. As such, there are potential fault lines where the state-controlled segments have prices governed by policy geared toward containing inflation, while the other segments are more market driven. For example, electricity producers’ revenue has suffered from price controls, but they also face rising input costs from market- priced commodities such as coal.

Our fund is positioned toward domestic economic activity rather than external activity, so we haven’t held a substantial weighting in export manufacturers for a number of years. China is concentrating on developing its domestic economy to engineer a shift toward a more self-sustaining economic model. From an economic perspective, export manufacturing still plays a crucial role in China’s economy because it’s the source of the higher wages that drive consumer demand. But export-oriented businesses are not attractive investments because of pressures they face from falling demand, rising input costs and wage inflation.

Ben: Is the worry over China’s slowdown justified?

Edmund Harriss: I’m surprised the market has taken this news so hard. The Chinese government was noticeably more cautious about its expectations for future economic growth than a number of external forecasters, but somehow that was ignored. The market focuses heavily on gross domestic product (GDP), which is a highly politicized number, instead of paying greater attention to underlying economic indicators, which pointed toward slowing domestic economic activity.

China’s slowdown requires a more nuanced analysis. While its economy may be slowing, it’s still growing faster than most countries in the rest of the world. So we try to find the sources of future growth and direct our investments accordingly.

China is moving to a slower, but more profitable growth model over the coming years. So we’re focusing on domestic stimulus efforts such as social housing construction programs, which will support consumer durables manufacturers; efforts to boost consumption through rising wages; and some fiscal stimulus measures. Meanwhile, we remain cautious about areas where the government is attempting to rein in prices, such as the real estate sector, or areas where the government is unable to exert much influence, such as external demand for manufactured goods.

The market’s negative reaction to the government’s lowering of its official GDP growth target to 7.5 percent is a highly simplistic way of viewing the situation in China. This latest policy is merely formal recognition that growth will not be as robust this year as it was in years past. It’s also a sign that policy will be much more supportive of growth in the coming year after having restrained growth for the past 18 months

Ben: Where are the pockets of strength in China?

Edmund Harriss: Energy, materials and industrials are still the areas that, from a value perspective, interest me most. From a growth perspective, these industries are still benefiting from China’s efforts to create a consumer-driven economy.

So we’re playing this theme through investments in the auto sector such as Dongfeng Motor Group (Other OTC: DNFGF.PK). It manufactures auto- mobiles with smaller engines that are generally more afford- able than premium brands.

On the technology side, we favor Internet stocks such as game portal NetEase.com(NasdaqGS: NTES) and online portals such as Tencent Holdings (Other OTC: TCEHY.PK) and SOHO China Limited (Other OTC: SOHOF.PK). They reflect the ability and willingness of younger and wealthier Chinese to spend. These stocks also offer good value because they’re asset-light and generate significant cash flow. The standard approach to playing consumer demand is to focus on the retail sector. But what some investors fail to apprehend is that businesses that operate in this sector require substantial capital and face intense competition.

We also like China Mobile(NYSE: CHL), a mobile phone business with about 655 million customers. It has a strong balance sheet and a good track record of managing itself and maintaining investment returns. China Mobile also pays an attractive dividend, with a 43 percent payout ratio. The company has been trying to transition into 3G technology, but has been hindered by China’s desire to develop a domestic version that hasn’t really worked. Instead, it’s now poised to jump straight into 4G. China Mobile is also a play on domestic consumption because about 90 percent of revenue is still derived from voice service and text messaging. As disposable incomes continue to rise, data usage will become an increasingly important source of revenue.

Ben: In addition to export manufacturers, should investors avoid any other sectors?

Edmund Harriss: From a current investment standpoint, I’m not especially fond of the banking sector. Banks are approaching their loan-to-deposit ratio ceiling of 75 percent, especially the mid-tier banks, so they’ll need to raise additional capital in order to keep lending. Should that happen, then it might encourage larger banks to follow suit.

However, I’m not particularly concerned about nonperforming loans, which is an area that’s caused considerable anxiety for other investors. China’s banks have a substantial capital base and are well funded. Unlike Western banks, Chinese banks don’t rely on wholesale markets, and they have a large, captive deposit base. And a bank that’s funded by a substantial deposit base is a more secure institution.

Additionally, China is unlikely to face a potential debt crisis any time soon because it has a closed capital account and most of its debt is incurred domestically. That means it won’t face the sort of pressure from external institutions that helped spark the sovereign-debt crisis in Europe. But while the banking sector is secure from a macroeconomic perspective, it doesn’t offer any investment opportunities right now because banks need to raise additional capital.

Ben: What is your best piece of advice for investors over the next year?

Edmund Harriss: U.S. investors should seriously consider building an allocation to international investments. The US economy is improving, but it’s still vulnerable to a rising interest rate environment, rising inflation or a combination of both.

Emerging markets may seem risky, but they’re well capitalized and growing. And that growth has been spurred by a burgeoning middle class with rising disposable income. So emerging markets are a particularly attractive place for investors to put new money to work.

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About the Analyst

Benjamin Shepherd is a recognized exchange-traded fund (ETF), mutual fund and stock expert with an extensive background analyzing time-tested funds, including their managers and strategies. Ben looks for investments that have proven themselves in both bull and bear markets. Ben also specializes in covering emerging markets, pinpointing the most dynamic investments in developing nations for market-beating growth.

Ben is an analyst for Global Income Edge and regularly contributes to Personal Finance, Investing Daily’s flagship product.

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